One of every ten dollars Alrosa is hoping to borrow from investors this month has been provisionally set aside to advertise Alrosa at the next three Olympic Games – London, Sochi, and Rio de Janeiro. This is the largest purse of Russian philanthropy, advertising, or giveaway ever publicly offered to western bond buyers to approve, and to fill.
It dwarfs the annual Easter egg-roll patronised by the Romanov tsars, which has boosted the Faberge brand-name. It may be the first time a major diamond marque has judged the mass sports market to be a source of untapped diamond jewellery spend.

The 345-page Alrosa bond prospectus was compiled by JP Morgan, UBS, and the Russian state bank which dominates secured lending to Alrosa, VTB. It was released to investment banks and funds last week. The $1 billion value of the unsecured note issue – through a Luxembourg entity, guaranteed by an Irish entity – has been reported by Reuters, and has yet to be confirmed officially by Alrosa.

According to the prospectus, “ALROSA expects to use the net proceeds of this Offering to refinance its existing short-term indebtedness.”

The financial accounts of the company do not itemize spending on market promotion or advertising, so it is impossible to say how much Alrosa has been spending recently. But this is unprecedented: “Potential Expenditure relating to Olympic Games Sponsorship”.

In order to increase international brand awareness, Alrosa has had preliminary discussions with Olympic Committee representatives about becoming an official sponsor of the London Summer Games in 2012, the Sochi Winter Games in 2014 and the Rio de Janeiro Summer Games in 2016. No decisions or agreements have yet been made on either side. If Alrosa were ultimately to become an official sponsor, it would have to pay US$100 million or more and would enjoy the marketing and promotional opportunities available to Olympic sponsors.”

If marketing, advertising and sponsorship are properly accounted for as a cost of sales, this tabulation by Alrosa appears to lump it in with wages and salaries. The potential for a blowout of costs on Alrosa’s balance-sheet from the Olympic Games venture is almost equal to the entire cost of operating for six months.

In their latest Alrosa rating report, issued on October 19, Standard & Poors announced it is lifting the company’s long-term credit rating to BB- from B+, principally because the global diamond business is looking up. But the report cautions: “We still regard Alrosa’s stand-alone liquidity as “weak”, although we note substantial improvement over the last six months on the back of successful issuance of RUB26 billion in ruble bonds and some medium-term bank loans. As of Sept. 30, 2010, we estimate that sources of liquidity may not fully cover
uses of liquidity during the next 12 months. However, the planned bond issuance, if applied to repay short-term debt, will be an important mitigating factor.”

In its liquidity measurement, S&P appears to have missed the $100 million Olympics item.

There is no reason for doubting that Alrosa deserves to be better known globally, for the company makes the point early on in the prospectus that it is “is the largest diamond mining company in the world by diamond production, based on carat volume.” This is based on the result of diamond mining last year, when the document says “the Group produced approximately 30 per cent. of the world’s rough diamond output, measured as a multiple of average market prices for the year, and approximately 28 per cent. by carat volume.”

What Alrosa doesn’t tell its future bond holders is that the year 2009 was so bad for De Beers, the other diamond mining giant in the world had to close several of its mines temporarily. This meant that with an announced mine output of 34 million carats for the year, Alrosa was well ahead of De Beers, which produced just 26.9 million carats. As has been reported before, when Alrosa first claimed the top spot in its releases, De Beers has capacity to return its production to levels well above Alrosa’s capacity: in 2007, De Beers produced 50 million carats; in 2008 48 million. This year so far, De Beers says that “carats recovered in H1 2010 amounted to 15.4 million, more than double those for H1 2009 (6.6 million carats).” If Alrosa is able to repeat its 34-million carat performance this year, and if De Beers gets up to 31 million carats by year’s end, Alrosa will still be number-1, though the gap is closing.

The problem is that Alrosa won’t disclose full carat data to allow a clear picture of what is happening at the mines. A first-quarter production report disclosed that mine production to March 31 was 8.6 million carats. A second-quarter report indicates that production fell slightly to 8 million carats. So far, there has been no production report for the third quarter.

Alrosa’s claim to top spot for its bond offer is paradoxical because release of the 34-million carat number last year looks likely to be a one-off event. Alrosa explains that although carat data for both mine output and mine reserves are no longer state secrets, it isn’t going to release them. That’s because the company thinks investors don’t need to know. Instead a warranty letter has been attached to the prospectus from junior officials of the Finance Ministry and the Ministry of Natural Resources. They certify that “approved reserves of rough diamonds (categories A+B+C1), as of January 1, 2010, are sufficient to permit extraction over the next 24 years, i.e., until December 31, 2034, of an average annual volume of diamonds at least as great as that extracted during 2009.”

Naturally, what this means is that the 34-million ct output of 2009 should be multiplied by 24 years to arrive at the disclosure, for the first time ever, that Alrosa has mineable diamond reserves of 816 million cts.

Notwithstanding, the Finance Ministry isn’t proposing to put its money where its mouth is. “Nothing in this letter may be construed as a commitment by the Ministry of Finance of the Russian Federation to guarantee the performance of any payment obligations with respect of the interest on, or the principal of, the securities of AK ALROSA (ZAO), and no such securities contain any obligations or guarantees of any such authority.”

Alrosa explains its non-disclosure policy this way: “Information about volumes of diamond reserves, as well as extraction, production, delivery and consumption of natural diamonds was previously considered a state secret under the Law of the Russian Federation “On State Secrecy” dated 21 July 1993, as amended and related presidential decrees. Although these restrictions were lifted for diamonds not held by Gokhran or the CBR in 2004, ALROSA’s internal diamond reserves estimates and estimates of the productive lives of mines have been prepared for purposes of regulatory submission to the Ministries of Natural Resources and of Finance of the Russian Federation, and for internal planning purposes and solely on the basis of standard Russian reserves methodology, which differs in material respects from the methodology used in other countries. These estimates have not been the subject of any review or examination by an independent mining engineer. Because of this and because the format, nomenclature, units of presentation and methodology for preparing ALROSA’s internal reserves information differ substantially from international presentation standards, ALROSA believes that such information would be of limited utility to investors, and accordingly, that information has not been presented in this Prospectus.”

In order to address the debts and risks the company says it wants a fresh billion dollars to deal with, the prospectus reveals information that has not been made public before.

Already published are the list of Alrosa’s debts and obligations, totalling $3.7 billion:

– “(1) Short-term loans without current portion of long-term debt includes RUB27,766 million (US$890 million) of bank debt, RUB10,848 million (US$348 million) of notes issued under the ECP Programme, RUB302 million (US$10 million) of commercial paper, RUB1,822 million (US$58 million) of other debt and RUB2,961 million (US$95 million) representing the current portion of long-term debt. As at 30 June 2010, there were no short-term loans secured with the assets of ALROSA.

– “(2) Long-term debt and current portion of long-term debt includes RUB27,834 million (US$892 million) of bank debt, RUB15,576 million (US$499 million) of 2014 Notes, RUB26,000 million (US$833 million) of Rouble denominated non-convertible bonds, RUB536 million (US$17 million) of finance lease obligations, RUB297 million (US$10 million) of commercial paper and RUB1,548 million (US$50 million) of other long-term indebtedness. As at 30 June 2010, there was no long-term debt secured with the assets of ALROSA.”

Here are the sales report and profit and loss balance-sheet:

Among the new disclosures, the prospectus says that Alrosa was marketing and selling its rough diamonds, as well as polished, through a Russian intermediary called Interdiam, which in turn was controlled by Almazzolotokomplekt, a supplier of machines and electrical supplies to Alrosa. Why exactly this structure was used for the sale of almost $400 million in diamonds in 2008 isn’t made clear. What is admitted is that 16 different sales agreements were signed with Interdiam on December 24 and 25, 2008, and in the months that followed, Interdiam failed to sell anything. Alrosa says it has bought back and resold $349 million of these goods.

On the export market, Alrosa says it has long-term sales agreements with manufacturers and cutters, as well as wholesalers, who are distributed geographically like this:

Fifteen of these long-term buyers have deals that run until 2014, with sales that amount to 31.3% of Alrosa sales for the first half of this year (Rb6 billion, $194 million). Another nine of these customers have contracts lasting until 2012, and their purchases amount to 16% of the sales in the first half of this year ($32 million).

Alrosa reports that one of its big domestic clients, Smolensk Kristall, the largest diamond cutter and exporter of polished diamonds in Russia, has received $93 million worth of stones in the first half of this year; $53 million worth in all of 2009; $163 million in 2008; and $145 million in 2007. About $25 million still remains to be collected, Alrosa says.

Much more problematic, the prospectus says, is the Sakha region diamond manufacturer called Tuymaada Diamond of Yakutsk, Sakha republic, in which Alrosa held a 13.27% shareholding. It appears to have defaulted on $2.2 million worth of diamonds, and “there has been substantial doubt as to whether it will be able to settle its outstanding accounts receivable with ALROSA.” So Alrosa headquarters have sold the debt to EPL Diamond, which has operations in Russia, Israel, the US and China.

The prospectus also lifts the lid on several potential insolvencies within the Alrosa group of companies – one of them at Alrosa’s Arkhangelsk region mining company, Severalmaz; one at a Sakha region oil company, Irelyakhneft; and one at an iron-ore miner, Timir. “If an involuntary liquidation or claims for early repayment of obligations were to occur,”the prospectus admits, “they could have a material adverse effect upon the Group’s business, results of operations and financial condition.”

These are small beer, though, compared to the biggest of the corporate finance risks identified in the prospectus, amounting to more than $1 billion. This has been reported before as stemming from a foray into non-core asset buying which Alrosa pursued under board chairman, Alexei Kudrin, the federal finance minister. Morgan Stanley was the arranger.

The company is on the hook to VTB, a state bank, which Kudrin also supervises as chairman of the bank. The risk, says the prospectus, is that “ALROSA may be required to repurchase certain Russian oil and gas companies (the “Gas Companies”) in September 2012 for a total price of between US$1.1 and US$1.2 billion, if the current owners, affiliates of VTB Bank, do not decide, in their sole discretion, either to retain the Gas Companies or to sell them to one or more third parties. The Group currently has no financing arranged for such possible repurchase. At the time the Gas Companies were sold by the Group in October 2009, they had certain business and financial problems, including non-compliance with the terms of their exploration and production licences, that, if unresolved, could give rise to liability under warranties and indemnities given in connection with their sale and could materially and adversely affect their fair value and their saleability to any third party. To ALROSA’s knowledge, certain problems have been addressed but others remain unresolved.”

If the dealmaking was a piece of financial genius by Kudrin, sitting on both boards, there has been no explanation from him of what went wrong with his judgement. The reason the deal sequence was attempted, Alrosa now says, is that it was “part of a strategy to diversify mineral resource production. This strategy has subsequently been abandoned.” What other strategic decisions by Kudrin for the Russian diamond business, which might also have to be abandoned, is a question for the roadshow now under way.